Australia: A case of Dutch disease?

As the resource boom subsides, David Llewellyn Smith of MacroBusiness looks at the symptoms, and opportunities, that a case of Dutch disease offers.

Key Points

Be wary of discretionary retailers, most miners and banks

Interest rates unlikely to rise quickly

Opportunities exist in companies with offshore, non-China earnings

In the 1970s, The Netherlands enjoyed a North Sea gas boom that pushed the value of the Dutch Guilder through the roof. That damaged manufacturing output, a phenomenon The Economist magazine termed ‘Dutch disease’.

The symptoms should sound familiar. The existence of Dutch disease, or the ‘resource curse’ as it is sometimes known, is uncontroversial. Large oil and gas discoveries in the UK, Norway, Nigeria and Russia all produced their own versions of Dutch disease. Australia has it alright. The big question is where we sit in this cycle and the implications for stock investment strategy.

A resource sector boom can inflate the currency and the inflation rate, depending on factors such as labour market flexibility and currency convertibility. Either way, the end result is a loss of competitiveness in tradable sectors like manufacturing.

Australia’s last two commodity booms make the point. During the 1970s boom, the country had a fixed-rate currency so as the need for labour expanded beyond capacity much of the inflation transpired in wages. This time around, the Reserve Bank of Australia (RBA) has tried to avoid wage inflation by raising interest rates and pushing the currency very high instead.

Structural adjustment

The result was a shakeout in our tradable sectors (those that export or compete with imports), which meant demand for labour fell in those areas and could be soaked up by rapidly expanding mining. That’s an IMF-approved definition of structural adjustment.

The RBA chose a different course this time around for two reasons. First, it had at its disposal a floating exchange rate, a tool not open to it in the 70s. And second, the RBA judged this commodities boom to be more enduring than those of the past. Therefore a permanent (structural) adjustment to more resource exports and less non-resource exports made more sense.

Trouble is, that expectation has only partly been borne out by experience. The boom has ended earlier and more suddenly than the RBA anticipated (see Chart 1) and the bank finds itself facing ongoing falls in the terms of trade and dramatic falls in mining investment, with no obvious growth driver to replace it.

What to do? The RBA (and Treasury) have turned to housing to fill the gap. Although the rate cutting cycle has eventually produced a response in property prices and a more subdued return in construction, this is a limited growth avenue.

With Australian households’ already very high exposure to mortgage debt (see Macro Investing: A property price bubble?), authorities don’t want an extended housing boom. Glenn Stevens has warned Sydney housing speculators to back off (without much success) and to reduce market heat the RBA is examining new rules like loan-to-value caps similar to those deployed in New Zealand.

To retain near full employment the RBA must look to a lower dollar. This is the heart of the matter. The combined inflation of the currency, wages and prices must be reversed so that non-resource exporters and import competers can become competitive enough to invest again and fill the growth gap left by Dutch disease. And they can’t do that with a still-high dollar.

But even the 21% decline in the dollar since its peak at $1.10 has only made a small dent in the real exchange rate, as Chart 2 shows.

And this chart isn’t the worst of it. Australia’s real exchange rate against our non-resource competitors in developed markets like the US, UK and Japan remain at unprecedented levels.

So the dollar needs to fall much further, although it’s more complex than that. A falling dollar makes tradable products more expensive. But if wages are allowed to rise in response, the devaluation is lost in inflation and competitiveness is not improved. To cure Dutch disease you need a real devaluation with falling real incomes.

This is not a solution easily sold to voters or politician trying to win their votes. In an era marked by cowardly politicians addicted to ‘kicking the can’ rather than solving problems at their root, there’s every chance authorities will ignore what’s needed in favour of shorter-term stimulus measures. If the Chinese can’t manage it, what chance have we got?

Instead, the Government appears intent on replacing one building boom (resources) with another (residential housing) and improving competitiveness through a timid micro-economic reform agenda. Perhaps a potential wages breakout will sufficiently stir our politicians but if not, Australia will boom and then bust.

Where to invest

Where does that leave investors? Cash returns are unlikely to rise (as they do in a stagflation). If monetary policy is tightened it will be done with sloth rather than vigour. And inflationary bursts will hamper more rate cuts, at least until the RBA innovates with macroprudential tools.

Should that happen, bonds may prove more attractive as interest rates fall further. That will be a boost for share market valuations (the price component of P/E), although there are problems here, too.

On the earnings side of the equation, typical cyclical growth stocks like discretionary retailers won’t benefit hugely because incomes will be restrained.

Trouble is, these sectors are already priced for stellar growth. The likelihood is that these sectors will see earnings rise early in the cycle but less so as it wears on.

But some stocks, especially dollar exposed firms (for instance, Computershare and Resmed), will be great beneficiaries of a real depreciation and it is here that investors should be picking their enduring cyclical growth winners.

Miners versus industrials

Mining valuations are already low and they will be the biggest beneficiaries of a falling dollar, although there’s a rather large ‘but’.

The end of the commodities boom is still playing out, especially in the bulk commodities that dominate earnings. Coal is at the forefront of the correction and has fallen in price a lot already as well as seen some rationalisation in global production. With the Chinese ‘rebalancing’, there’s further to run.

But the big one is iron ore, which is still trading at exceptional prices. The iron ore supply glut is upon us just as China is slowing again. Its price may fall again this year, and very sharply if China does not boost growth with more stimulus, which its leaders have ruled out, although they’ve said that before and done it anyway.

Without more stimulus, there’s a high risk that iron ore will trade at an average of $100 a tonne and below this year, and lower again next year. Such average prices imply downside spikes to $80 and even lower. Neither volume growth nor a falling dollar, or cost reductions will be enough to offset severe price declines. High cost producers will be threatened and others tested. This is a sector to avoid.

A better investment strategy is to look to Australian firms that are exposed to the falling dollar but not to China’s transformation like the dollar-exposed industrials and energy firms. These will also benefit from the improved conditions in developed markets and ongoing global carbon mitigation.

There are serious questions over Australia’s gas boom in terms of long run viability owing to high costs of production. But those concerns are long term, particularly from 2018 onwards when US gas begins to flow. In the meantime, as local LNG projects approach completion, exports will flow and project risk will diminish. That’s an argument in favour of the sector for a medium term punt.

Industrials with international earnings are the most natural fit in a post-Dutch disease environment. They are leveraged to the global, and especially developed, economic recovery and will benefit greatly from the falling currency. Most importantly, they’re not exposed to the vagaries of a highly questionable Chinese transition.

David Llewellyn-Smith is the founding publisher and former global economy editor of The Diplomat magazine, Asia Pacific’s leading geo-politics and economics website. He is also the co-author of The Great Crash of 2008 with Ross Garnaut and a regular economics and markets contributor for Fairfax and the ABC. David is the editor-in-chief and publisher of MacroBusiness.

InvestSMART Publishing Pty Ltd holds Australian Financial Securities Licence (AFSL) 282288.
The content of this website is general in nature and does not take the personal situation of any user of this website into consideration.
A user of this website should seek financial advice specific to that user’s situation before making any financial decision.
Past performance of any security or financial product is not a reliable indicator of future performance. InvestSMART Publishing Pty Ltd
encourages users of this website to view investing as a long-term pursuit.